EU Could Prolong Brexit Political Pain For Economic Gain

Published date: Friday March 15, 2019.

In recent months, some European officials had begun to wish for a swift U.K. exit from the European Union, even if it meant a hard, no-deal Brexit. Better the recession we know, a Brussels-based diplomat said recently, than yet more uncertainty.

Investors can still hope, however, that a hard Brexit might be avoided, as Parliament this week ruled out the dreaded “no deal” scenario, and the pound
GBPUSD, +0.3776%
surged on the news.

The House of Commons has also now voted for the principle of extending talks with the EU beyond the date, March 29, on which Brexit was scheduled to happen. If MPs approve the withdrawal agreement that Prime Minister Theresa May plans to bring to a vote for a third time, then the U.K. will ask Europe for an extension of the talks to the end of June. The U.K. government would require a longer extension if it hasn’t been able to persuade the House of Commons to approve the deal on the table.

EU leaders considering the request at their summit in Brussels at the end of next week will ponder the economic consequences of their choice.

For now Europeans don’t seem ready to trade the elusive political gain of a fast break for the certain economic pain that a no-deal Brexit would impose on the continent’s economies. But Europe will only agree to an extension if it gets an assurance that it is worth the wait. In a tweet this week, the European Council’s president, Donald Tusk, said that EU leaders would be amenable to a long extension if the U.K. “finds it necessary to rethink its Brexit strategy and build consensus around it.”

Investors looking for clues on the Brexit impact on the European economy must contemplate several scenarios.

Bank of America Merrill Lynch economists have estimated that a hard, no-deal Brexit on March 29 could shave between 0.7% and 1% off the eurozone’s gross domestic product. That would bring the economy close to stagnation this year — the latest European Central Bank economic forecasts see growth at 1.1% in 2019.

In currency markets, the British pound also benefits when the prospects of a negotiated deal rise. Sterling jumped this week when Parliament voted to rule out a no-deal Brexit. That was more a political and legal statement than a final announcement of things to come. Despite the bump this week, the U.K. currency is down roughly 9% against both the euro and the dollar since the Brexit referendum in June 2016. It will resume its slide if the UK leaves without an orderly transition.

A long extension wouldn’t guarantee that a hard Brexit can be avoided. But the longer delay would help the EU push back its economic impact.

“The EU would be crazy not to accept,” summed up Gilles Moec, chief Europe economist at B. of A. Merrill Lynch.

“I wouldn’t like to look at the French GDP in the second quarter of the year” in case of a hard Brexit in March, he added. The idea being that a calmer, two-year extension would help cool minds, clean the slate, and allow both Brussels and London to start anew, at the price of redrawing a few red lines.

The economic impact of a longer extension is both a risk and an opportunity for Europe. On one hand, the practical and legal conditions of Brexit will remain unknown for many more months. More talking doesn’t mean less confrontation between the U.K. and the other 27 EU members. Investors may be subjected to a roller coaster of good and bad news. And the negotiations will play out against a backdrop of significant change among Europe’s leadership: Over the next few months, a new Commission, a new Parliament and a new European Central Bank president will take over, while German Chancellor Angela Merkel’s career has entered its twilight years.

On the other hand, a longer extension means, in the worst-case scenario, that Europe can postpone the actual hit of a hard Brexit by a year or two, and keep preparing for it in order to cushion the blow. And, if it all goes well, and if at some point the U.K. red lines shift toward remaining in the single market or in the customs unions, investors in both U.K. and European companies will be able to resume trading on economic fundamentals.

European leaders will also be mindful next week that they are facing other major economic risks, both domestic and foreign, from populism to rising trade tensions. For that reason alone, they could prefer the relative safety of a longer, conflictual cohabitation with the U.K. to the risk of a recession without it.